For a winning investment strategy, this year it has paid to bet against the smartest guys in the room.
Had an investor bought the 50 most popularly shorted stocks at the beginning of the year and held them through Friday, he would have earned an average return of 22%, including dividends, according to FactSet. That is nearly double the S&P 500's 12% total return.
One reason: Since so many hedge funds are scouting for stocks to sell short, good ideas are hard to come by.
Recall that to sell a stock short, an investor sells shares borrowed from another investor. The hope is to buy them back, for return to the original owner, after the price falls. But popular picks are often piled into, creating pent-up buying pressure that can cause otherwise bad stocks to appreciate rapidly.
After all, a troubled business and high valuation aren't the only considerations when betting against a stock. Another key is liquidity. If the number of shares borrowed by short sellers is significantly higher than average daily trading volume, it could take multiple days for them to buy back shares to cover bets. Indeed, for the top 50 mentioned above, shorts would have had to buy all shares traded over an average 38-day period to close their positions.
Lately a smart trade has been to buy popularly shorted technology stocks, including data-center companies Rackspace Hosting and Savvis, website OpenTable and prepaid-debit-card companyGreen Dot. Year-to-date, they are up 100% on average.
Solid fundamental analysis is paramount when betting against any company. At the same time, hedge funds must beware crowded trades, lest they get caught in the exit.
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